In­vest­ment banks’ pay poli­cies still pose risk to bond­hold­ers

De­spite ef­forts by reg­u­la­tors to re­duce em­pha­sis on short­term re­sults in de­ter­min­ing ex­ec­u­tive com­pen­sa­tion at the global in­vest­ment banks, the time pe­ri­ods to re­ceive com­pen­sa­tion awards re­main shorter than credit cy­cles and po­ten­tial tail risks, ac­cord­ing to a new re­port from Moody’s In­vestors Ser­vice.

“The com­pen­sa­tion re­forms at large banks have gen­er­ally been pos­i­tive, help­ing re­duce man­agers’ in­cen­tive to take on ex­cess risk,” said Christian Plath, a Moody’s vice pres­i­dent. “How­ever, even with th­ese changes, per­for­mance, vest­ing and de­fer­ral pe­ri­ods are still too short to cover credit cy­cles and po­ten­tial tail risks.”

The changes, which in the US, UK and con­ti­nen­tal Europe have been driven by reg­u­la­tory mea­sures as well as business op­er­at­ing prin­ci­ples, in­clude re­duc­ing the ab­so­lute size of an­nual in­cen­tives, de­fer­ring a greater por­tion of com­pen­sa­tion to the fu­ture and sig­nif­i­cantly re­duc­ing or elim­i­nat­ing the use of stock op­tions in long-term in­cen­tive plans.

How­ever, the changes have more closely aligned se­nior ex­ec­u­tives’ in­ter­ests with those of share­hold­ers by ty­ing com­pen­sa­tion more closely to share price per­for­mance and giv­ing share­hold­ers a greater say on ex­ec­u­tive pay, which could have credit neg­a­tive ef­fects. As Plath said, “the risk ap­petites and in­vest­ment hori­zons of share­hold­ers and cred­i­tors don’t al­ways align, and they’re likely to have very dif­fer­ent ideas of what con­sti­tutes an op­ti­mal pay struc­ture.”

The US based in­vest­ment banks have the short­est pe­ri­ods, gen­er­ally three years, whereas tail risks may play out over a 7-10 year cy­cle. In con­trast and driven by a reg­u­la­tory push, the vest­ing pe­ri­ods of UK and con­ti­nen­tal Euro­pean banks are gen­er­ally around 4-5 years and could be stretched fur­ther, bet­ter align­ing em­ployee com­pen­sa­tion with risk tak­ing and the longer-term con­se­quences of their ac­tions.